Updated: Aug 4, 2019
According to usdebtclock.org, total personal debt in the United States is nearing $20 Trillion, with $1.6T in student loan debt and $1.1T in credit card debt. The average personal debt per citizen is nearly $60,000. For a family of four, that’s $240,000 of household debt, a staggering number! This poses the question, “Is all of this debt necessary?” The answer is both yes and no, because debt can either be good or bad.
Good debt is debt that is used as a reliable investment which will grow in value or generate long-term income. Taking out student loans to pursue a degree in order to increase your income in the future is good debt, such as taking out a student loan to attend medical school. Even though you accumulate debt, your future salary as a doctor will allow you to easily pay off the loan and make substantially more money (Note, making more money is a good thing if the money is spent for good reasons, such as helping others and saving for retirement. It becomes a bad thing if it is used for evil purposes or leads to greed). A home mortgage that accounts for less than 30% of your income is also good debt, because your home usually appreciates in value and therefore leaves you with a positive return on investment compared to renting. Good debt often has low interest rates, typically less than 5%. In order to own a home or go to college, good debt is often necessary, since few people have the means to pay for a home or a degree upfront in cash (although it is possible!).
Bad debt is debt used to purchase risky investments or items that depreciate in value. Bad debt typically has astronomical interest rates, often over 20%. For example, taking out a loan to invest in the stock market is a bad debt because of the risk involved. Payday loans are bad debt because of their high interest rates and exorbitant fees. Credit card debt is also bad debt, because interest can accumulate rapidly and quickly drown you in debt, which is very difficult to repay (If this is you, learn how to use credit cards responsibly). Car loans are usually bad debt because a vehicle’s value depreciates rapidly, which leaves you owing more on the car than it is worth.
Finally, taking out a student loan to pursue a degree that does not guarantee higher income in the future is bad debt. For example, taking out over $100,000 in student loans to finance a degree with limited earning potential (for example, art history) is an extremely bad idea, because 1) you will have a difficult time repaying the loan with your post-graduate salary and 2) you can earn the same income with an art history degree as someone with no degree at all. Thus, student loans with a negative return on investment are bad debt.
Of course, there are exceptions to these classifications. For example, a car loan can be good debt if the rate is low and the car is absolutely necessary to do your job and earn an income. Additionally, mortgage debt can be bad debt if you initially overpay for the home, preventing you from recovering the amount you borrowed. However, most people will find that their debt can be classified as described above.
So what do you do if you find yourself with bad debt? Pay it off as soon as possible! Check out How to Get Out of Debt to get started.